Depository Safety and Economic Safety

How did the free banking system perform in terms of
depositor safety and promoting economic stability? Rolnick and
Weber (1982) studied four free banking states (New York, Indiana,
Minnesota, and Wisconsin) for which they found data on 709 free
banks during the period 1838-1863. They found that about half of
those banks failed with about a third of those unable to redeem
their banknotes for specie. Overall, about 16 percent of the
free banks in those states could not redeem their banknotes. In
addition, free banks were short-lived relative to modern banks.
About 16 percent of free banks existed for less than one year,
with the overall average about five years (Sechrest, 99). In the
four states they studies, Rolnick and Weber estimate depositor
losses ranged from $1.6 million and $2.1 million per state.

Nearly all of the free bank failures, Rolnick and Weber
argue, were due to sharp declines in the market value of the
bonds the banks held rather than being caused by fraud, as seems
to be the popular perception. They were caused mostly by the
legal requirement to tie note issues to the market value of the
bank's bond-holdings. When the market value declined
substantially, the bank was required by law to withdraw some of
its currency from circulation. It did this by calling in loans,
an act which frequently put a tight credit vice on businesses and
which shrank the money supply.

In terms of economic stability, the free banking era was
characterized by considerable swings in the money supply and the
price level, as is shown in the table below.

(Sources: John Knox, A History of Banking in the United
States, New York: Bradford Rhodes, 1903; and Historical
Statistics, 1960, series E 1-12.)
Kidwell and some other economists blame the state banking
system for contributing to the volatility in the economy, even if
it did not directly cause it. In the initial expansionary phase
of the business cycle, overly optimistic banks would issue too
many banknotes which would accelerate the growth of the economy.
However, this would eventually lead to inflation and an
over-extension of credit. A random downturn in key commodity
markets would then sharply reduce the market value of many bonds
and loans, and banks would be forced to call in loans and
contract the money supply. Sometimes this led to cases of
depositor panic and further reductions in the money supply, which
brought the next contraction of economic activity (Kidwell,
56).

Most economists regard the free banking era as on balance
being a de-stabilizing influence on the developing U.S. economy.
Edward Symons writes "In some states, particularly Michigan where
more than forty banks failed before the system was declared
unconstitutional, the system is better characterized as a fiasco
than a failure" (Symons, 22). However, free-banking advocates
claim that this period is not a true test of their theory
(Rolnick and Weber, 19-20). In particular, the legal requirement
in most free banking states that note issues be tied to the
market value of bonds limited the management to sub-optimal
choices in terms of their note issues. In current free banking
theory banks would have the incentive to issue a profit-
maximizing volume of notes which would be based on economic
factors, not exogenous regulations, and that this quantity of
notes would not, in theory, cause monetary instability (Sechrest,
16-17).

Regardless of its merits or its problems, the free
banking
era ended in 1863 with the passage of the first of the National
Banking Acts. These laws reasserted federal influence in the
functioning of the nation's financial system.